‘Deflation’ is a dumb way to approach tokenomics… and other sacred cows – Cointelegraph Magazine

[ad_1]

Having taught and studied token economics at the University of Nicosia, I’ve found that students often have some decidedly muddled beliefs about how what tokens are and how business and token economies work.

Unlike microeconomics and macroeconomics — which are based on decades of research, debate and inquiry that have produced some commonly accepted principles — tokenomics is a much newer field of study full of people without economics experience.

There are many self-professed “experts” who provide advice that sounds fine and is often even sensible in theory but that fails in practice.

When designing a token economy, what you really want to focus on is:

Is the economic strategy repeatable?

Is there some way of diagnosing when and how to deploy the strategy for your token and the estimated value of doing so?

Is there research that validates the strategy so you can talk about it more credibly?

Deflationary tokens

Take, for instance, the idea held dear by many that deflationary tokens have an absolute advantage. “Deflationary” means an ever decreasing supply of tokens, which in theory increases the purchasing power and value of each remaining token. “Inflationary” means the opposite: an ever increasing supply which, in theory, reduces the value of each token.

You’ll hear commentary along the lines of “how deflationary tokens empower a crypto project’s value” from blockchain pundits such as Tanvir Zafar celebrating the limited supply of Bitcoin and the deflationary supply of Ether following the Merge.

It’s an idea even propagated by a widely recognized community for tokenomics best practices, the Tokenomics DAO, which has a “Tokenomics 101” page that states:

“People who understand Bitcoin will see great value in the fact that it is so simple, elegant and has a limited total supply. Bitcoin’s tokenomics have created digital scarcity that is enforced (through token incentives) by the network.”

But while many token designs emphasize deflation, “they are not optimally designed,” according to Will Cong, the Rudd family professor of management and faculty director of the FinTech at Cornell initiative at Cornell University.

Taking their cues instead from tweets and community ideologies, “many platforms also can’t even write down a logical objective for their token supply and allocation policy,” Cong continues.

Focusing on whether a token is inflationary or deflationary shifts attention to second-order issues. The price of a token can always adjust to meet supply, and each token can be arbitrarily fractionalized, so a fixed supply is a moot point if the token does not provide value to end-users.

Is Solana inflationary or deflationary or both? — Is SOL inflationary, deflationary or both?

“In fact, some inflationary coins with robust burn rates may regularly switch between being inflationary or deflationary, like Solana,” explains Eloisa Marchesoni, a tokenomics consultant. “The inflation rate started at 10% and will reach its final rate of 1.5% in about 10 years, but there are also deflationary features, like a percentage of each transaction fee getting burned.”

“With enough transactions per second, the transaction fees that are burned could be even higher than 1.5% per year if many transactions occur, which would bring Solana’s inflation rate to 0% and make it deflationary in the long run.”

Token price falls and deflation

Although cryptocurrencies behave very differently than traditional asset classes — according to research by professors Yukun Liu and Aleh Tsyvinski — they are heavily influenced by momentum and market size. In other words, investor sentiment and the number of users on a platform are significant predictors of cryptocurrency returns and volatility.

Fluctuations in the valuation of traditional asset classes may not have a direct effect on crypto, but they can indirectly affect it through spillover effects. For example, changes in interest rates will dampen the risk appetite of investors who are heavily exposed to sectors like real estate.

In this sense, even if a token has deflationary properties, a common macro shock that stifles aggregate demand renders these deflationary properties less useful since the decline in demand lowers the price of the tokens, and as a result, they cannot buy as much.

That said, in general, the cryptocurrencies with the highest market cap are also the most resilient to the current global recession, so we are mainly talking about Bitcoin and Ether.

Novelty tokenomics

Many tokens with novel tokenomics have risen with transient social media momentum but subsequently collapsed as the fads passed.

“SafeMoon relied on heavy selling fees and deflationary mechanics to convince holders that the price would go up endlessly even though the protocol never actually identified the problem it was actually solving,” says Eric Waisanen, chief financial officer of Phi Labs Global.

“Similarly, Olympus DAO inflated their OHM token in accordance with its price, even advertising (3,3), a misrepresentation of simple game theory, which told holders that if none of them sold, they’d all get rich.”

Is SafeMoon safe? Is it smart? (Source: SafeMoon)

Another big shortcoming of tokenomics strategies is their emphasis on holders staking their tokens to earn a high yield. A large yield that lasts for a day, or even a month, is not helpful for consumers and investors who take the long view. Instead, it attracts the wrong crowd.

“The use of staking options to lure extractive users into the project usually does not end up well, causing volatility or the risk of market prices and token price fluctuations, which will stress the whole tokenomics and may end up breaking it if not adequately tested already with simulations under extreme conditions,” Marchesoni explains.

Take, for instance, Helium, a project that uses open-source technologies to create a decentralized and trustless wireless infrastructure. Its tokenomics strategy offers people the possibility of becoming a validator by staking at least 10,000 of its native HNT token, but those who do risk significant volatility by locking up their tokens for months — perfectly demonstrated by the fact its price went from over $50 to $2 within the space of approximately one year.

Other projects — such as the business-focused VeChain ecosystem, which specializes in supply chain tracking – have endeavored to address the volatility in token prices by creating two separate tokens. The first, VTHO, is used to pay for network access and deals with the predictable component of supply and demand for the product or service. The other, VET, serves as a value-transfer medium, with VET stakers “generating” VTHO.

What APR is too high?

While proof-of-stake protocols such as Ethereum rightly incentivize staking because it secures the network, the emphasis can get misplaced the further down the line you go.

“Now we’re seeing inflation rates well over 20%. Evmos, an EVM-compatible chain in the Cosmos ecosystem, currently has a 158% APR for staking. Similarly, layer-2s are giving staking rewards just for holding a token without having a blockchain to secure,” Waisanen says.

Headline APR for Evmos, and ‘Adjusted Reward’ — Headline APR for Evmos and “adjusted reward.” Source: Staking Rewards

These “APRs” for holders are misleading because the supply of the tokens continues to grow, but the liquidity of the token is constant, so these APRs are not sustainable.

Moreover, when you see high yields, you have to ask yourself how they are sustainable. Ethereum co-founder Vitalik Buterin summed it up best on Twitter during 2020’s DeFi “yield farming” craze, stating:

“Honestly I think we emphasize flashy DeFi things that give you fancy high interest rates way too much. Interest rates significantly higher than what you can get in traditional finance are inherently either temporary arbitrage opportunities or come with unstated risks attached.”

While these incentives have been abused, staking can be important for securing a network and ensuring price stability.

“Too much emphasis on tokenomics has been placed on generating returns for early adopters and users of tokens rather than driving utility values,” says Gordon Liao, chief economist at Circle.

“In this deep crypto winter, the sentiments around tokens have entirely shifted. Even VCs are starting to place more weight on the equity components rather than the token component when considering new investments. Some protocols have even opted to airdrop USDC instead of their protocol-specific tokens.”

Crypto airdrops

Some projects have turned to airdropping users with tokens for marketing purposes. And while my research suggests that airdrops, on average, have a positive effect on market capitalization and volume growth, how the airdrop is done also matters.

For example, those that use bounties – or establish requirements that involve boosting and posting on social media to claim the airdrop – tend to perform worse. Airdrops on decentralized exchanges and those that involve governance tokens tend to perform better.

“Uniswap and Ethereum Name Service launched successful airdrops where the greedy users were converted into active members of the community, thanks to the great game-theoretic model that these projects had put in place,” says Marchesoni.

There was great turmoil on Sept. 17, 2020 when Uniswap airdropped its UNI token, but it was also only a matter of time until most users cashed out. But over two years later, there is still a group of dedicated UNI holders, and tokens are still being claimed today.

Airdrops can be a great way to build communities.

Uniswap remains the leading decentralized exchange, and its UNI token provides governance rights to those willing to get involved. The Ethereum Name Service airdrop was also fairly successful, turning many recipients into active members of the community thanks to its game-theoretic approach to the airdrop.

Admittedly, however, there have also been many failed attempts at airdrops, including the most recent APT airdrop by buzzy project Aptos, set up by some of Meta’s former Diem team. It airdropped between $200 million and $260 million in tokens, but when news of FTX hit – with FTX Ventures co-leading its round of funding – the momentum dried up, and people began to sell the token while they had a chance. As in comedy, good timing is essential, and projects need to recognize the broader economic environment that they’re operating under, who they accept capital from, and which blockchain they build on.

Are crypto tokens like stocks?

A final misconception is that tokens are equivalent to stocks. While governance tokens or even NFTs can appear to inherit similar features as stocks — such as governance rights or dividends — most have not.

“The vast majority of NFT art projects […] convey no actual ownership for the underlying content,” according to Alex Thorn, Galaxy Digital’s head of research. There is nothing stopping nonfungible tokens from conferring greater rights and benefits, but collections have historically not been designed as such. Similarly, DAO governance tokens can provide dividends from project revenue, but many tokens, including Uniswap’s and Optimism’s, do not.

Professors Cong, Ye Li, and Wang have shown in their research how tokens can solve important principal-agent problems, particularly for startups, but the reality remains that many tokens are receiving valuations commensurate with corporate stocks, which is not sustainable.